Friday, November 20, 2009

In Which I Contemplate Creative Financing

This article about Borders got me thinking. Borders has had financial trouble for a while, and the article states that Borders had its credit insurance cancelled as a direct result.

We've all heard the stories about health insurance companies cancelling policies and benefits. They are not supposed to cancel individual policies, but they can eliminate a class of policies that are proving unprofitable.

I don't support this. Insurance should be a collective pool of risk, not a game of chicken.

However...things being as they are...

Think back to 15 months or so ago. The economy was accelerating down a slippery slope. At the core, the decline in real estate prices beginning in 2007 led to the bottom falling out of the mortgage-backed securities market. These were owned by brokers, hedge funds, and a swath of smaller investors.

These mortgage-backed securities were often insured. During 2008, mortgages failed and insurance was paid out. Then the insurance ran out.

The property/casualty insurance company AIG had been known for insuring unusual risks--big concerts, stunts, etc. They appraised risks well enough to make insurance both affordable and profitable. They were known as a class act, and they consistently met regulatory reserve requirements.

The credit insurance subsidiary of AIG was none of these things. They sold everyone insurance on investments without keeping cash reserves for the risks they were insuring. They didn't seem to recognize the possibility of a massive run on claims even after a decade of unusually volatile market activity. They didn't seem to know or care what the consequences of their actions might be.

It was AIG that got the first big chunk of bailout money a year ago--money it used to pay policyholders 100 cents on the dollar of their claims. This is the major reason that Goldman Sachs was able to bounce back so soon. Goldman was so cash-poor that it had to take government money at the end of last year. Once AIG paid off Goldman's claims, it was able to repay the government with interest and post a $4 billion profit by the second quarter of this year.

Not everyone got bailed out. Stock values fell around 40%--no bailout for us. Lehman Brothers bondholders have no backup plan. Anyone insured through smaller credit insurers didn't get bailed out. When the claims reserves ran out, that was it. But AIG got bailed out because it was special: it was declared too big to fail. And AIG in turn passed that money on to big players like Goldman--and others who caused the problem in the first place by both creating mortgage-backed securities and increasing the demand for them beyond what the market could sustain. Goldman doesn't have to pay its claims money back to the government even though that's where it came from.

So here's my point: why didn't AIG simply cancel its insurance on all mortgage-backed securities when it saw the end coming? Or at least when the credit division ran out of money? Then the rest of the company wouldn't need a bailout.

But, you may argue, that's not fair to those who had the foresight to buy insurance. If you argue this, you have to also agree that cancelling other forms of insurance is not fair, either. Insurance policies should not be treated like callable bonds. I don't argue with this...

...but since we're already allowing insurance cancellation to happen to innocent people, why not include the guilty? In this case, the ones who were insured by AIG had created and profited by these dud investments and then moved the risk of failure to someone else. Why not move the consequences of failure back on the creators?

The money would still be gone, and the bailout still would have happened (though not for 100 cents on the dollar!), but there would have been an important bookkeeping change. Instead of the bailout money going through AIG to Goldman et al, it would have gone straight to AIG's policyholders. And Goldman, et al, would still owe it back to the taxpayers. With interest.

No comments:

Post a Comment